Wednesday, March 15, 2017

US Flow of Funds: ETFs Driving Stocks Higher

The Fed released its Financial Accounts of the United States with data for Q4-2016 last week. It provides amazingly comprehensive insights into the flow of funds, balance sheets, and integrated macroeconomic accounts of the US financial system. It’s really almost too much information to wrap one’s head around.

To help process it all, we have created a bunch of chart publications over the years that visualize quite a bit of it on our website. The saying that a picture is “worth a thousand words” is attributed to newspaper editor Tess Flanders discussing journalism and publicity in 1911. We have always believed that a chart is worth a thousand data points in a time series. Given our chosen profession, we tend to focus on the data for the equity and debt markets in the Fed’s quarterly statistical extravaganza. Let’s focus on equities:

(1) Supply-side totals. Net issuance of equities last year totaled minus $229.7 billion, with nonfinancial corporate (NFC) issues at -$565.7 billion and financial issues at $269.7 billion. The increase in financials was led by a $283.9 billion increase in equity ETFs, the biggest annual increase on record. The decline in NFC issues reflected the impact of stock buybacks and M&A activity more than offsetting IPOs and secondary issues.

(2) Demand-side total. To get a closer view of the demand for equities, let’s focus now on the quarterly data at an annual rate rather than at the four-quarter sum. This shows that equity mutual funds have been net sellers for the past five quarters, reducing their holdings by $151.3 billion over this period. Over the same period, equity ETFs purchased $266.4 billion, with their Q4-2016 purchases a record $485.4 billion, at a seasonally adjusted annual rate. Other institutional investors have been selling equities for the past 24 consecutive quarters, i.e., during most of the bull market! Foreign investors have also been net sellers over this same period.

The bottom line is that the current bull market has been driven largely by corporations buying back their shares, as I have been observing for many years. More recently, we have been seeing individual investors increasingly moving out of equity mutual funds and into equity ETFs. Both kinds of buyers tend to be much less concerned about historically high valuation multiples than more traditional buyers are.

We may be witnessing the beginning of an ETF-led melt-up, which may simply reflect individual investors pouring money into passive stock index funds. Lots of them seem to be more interested in seeking out low-cost funds rather than cheap stocks. In this case, valuation multiples would lead the melt-up, until something happens to scare investors out of those passive funds, which could trigger either a correction or a nasty meltdown. It is obviously a bit late in the game to start only now to be a long-term investor given that stocks aren’t cheap no matter how valuation is sliced and diced.